In the UK, we have an inflation target of 2% and it’s the Bank of England’s job to use monetary policy, in particular interest rates, to keep inflation within 1 percentage point of its target. However, with rising commodity prices and the onset of recession back in 2008, interest rates had another objective: to prevent or at least lessen the recession. Bank Rate fell to 0.5% and there it has remained in a bid to encourage investment, discourage saving and increase consumption, as a means of stimulating the economy.
However, at such a low rate, interest rates are not acting as a brake on inflation, which is now well above target. This rise in inflation, has been largely brought about by cost-push factors, such as the restoration of the 17.5% VAT (up from the temporary 15%), higher oil and commodity prices, and a fall in the exchange rate. But part of the reason might be found in the increase in money supply that resulted from quantitative easing.
There are concerns that the UK may lose its credibility on inflation if action isn’t taken. The OECD has advised the Bank of England to raise Bank Rate to 3.5% by the end of 2011. The following articles consider this issue.
Articles
Time to worry about inflation? BBC News blogs, Stephanomics, Stephanie Flanders (28/5/10)
UK must not fall for the false promise of higher inflation Telegraph, Charles Bean, Deputy Governor of the Bank of England (4/6/10)
Reports and documents
General Assessment of the Macroeconomic Situation OECD Economic Outlook, No. 87 Chapter 1 (see especially pages 53–4) (May 2010)
United Kingdom – Country Summary OECD Economic Outlook, No. 87 (May 2010)
Statistical Annex OECD Economic Outlook, No. 87 (available 10/6/10)
Inflation Report portal Bank of England (see May 2010)
Questions
- Explain the relationship between interest rates and inflation. Why have such low interest rates caused inflation to increase?
- In 2008, the UK moved into recession, but was also suffering from inflation. This was unusual, as AD/AS analysis suggests that when aggregate demand falls, growth will fall, but so will prices. What can explain the low growth and inflation we saw in 2008?
- What is the difference between real and nominal GDP?
- What are the causes of the current high inflation and what solutions are available and viable?
- Why are expectations of inflation so important and how might they influence the Bank of England’s plans for interest rates?
- Do you think the OECD should have advised the Bank of England? Will there be any adverse effects internationally if the UK doesn’t heed the OECD’s advice?
- Is the OECD’s assessment of the UK in the above Country Summary consistent with its view on UK interest rates contained in pages 53 and 54 in the first OECD link?
House prices are on the rise again and at the fastest rate since June 2007, according to the Nationwide. In June 2007, the average house price was £184,070, which did prevent many first-time buyers from getting on to the property ladder. Enter the recession. Over the past two and a half years, house prices have fluctuated considerably. Land Registry data shows that the average house price in April 2009 had fallen to £152,657, which gave first time buyers more of a chance, but at the same time mortgage lending fell and many lenders required a 25% deposit, which again ruled out many purchasers. Gradual increases in the latter part of 2009 and the beginning of 2010 have seen the average price rise to £164,455 (£167,802 according to Nationwide) and the trend looks unlikely to reverse, although it should stabilise.
Behind these changing prices is a story of demand and supply and the importance of expectations. As the credit crunch began and house prices began to fall, those looking to sell wanted to do so before prices fell further, while those looking to buy were expecting prices to fall further and so had an incentive to delay their purchase. In recent months, however, the demand for houses has out-stripped supply and it is this that has contributed to rising prices. At the same time, the stamp duty holiday that ended in December 2009 was re-introduced in the 2010 Budget and mortgage approvals have begun to increase. All of this has led to annual house price inflation of 10.5% by April 2010.
Articles
House price inflation hits 10.5%, says the Nationwide BBC News (29/4/10)
House price rise reaches double digits, finds Nationwide Telegraph, Myra Butterworth (29/4/10)
House price growth hits three-year high Times Online (29/4/10)
Taylor Wimpey says house prices rise 9pc Telegraph (29/4/10)
Bringing down the house price Guardian (27/4/10)
Data
House Price Data Nationwide
April 2010 Press release Nationwide
Halifax House Price Index site Lloyds Banking Group
(see especially the link to historical house price data)
House Price Index site Land Registry
Questions
- Using a diagram, explain why house prices fell towards the end of 2008 and the beginning of 2009.
- Using your diagram above, now illustrate why house prices have begun to increase.
- Is the demand and supply of houses likely to be price elastic or inelastic? How does this affect your diagrams from questions 1 and 2?
- Why is the upward trend expected to stabilise during the latter part of 2010?
- To what extent has the stamp duty holiday affected house prices?
- Has the recession had an impact on equality in the UK economy?
- Will rising house prices contribute to economic recovery. Explain why or why not.
The consumer prices index (CPI) is used by the government and the Bank of England for measuring the rate of inflation, and in the 12 months to March 2010 it rose by 3.4%. This figure was above the expected rate of 3.1% and well above the Bank of England’s target of 2%. The other major measure of consumer prices, the retail prices index (RPI) rose by even more – by 4.4%.
In order to recover from the recession, the UK economy needs to grow, but as demand begins to rise, this could put further upward pressure on inflation. There are a number of influencing factors that have caused the recent rise in inflation (see Too much of a push from costs but no pull from demand). Large rises in housing, fuel, transport, many household services and food were contributing factors. Many of these factors, however, are thought to be temporary, so it may not be too much of a problem.
And anyway, at least if inflation does continue to rise, it won’t be unexpected!
Articles
UK inflation rate rises to 3.4% BBC News (21/4/10)
A surprise? Definitely. A problem? Possibly. BBC News blogs, Stephanomics, Stephanie Flanders (20/4/10)
Transport costs push UK inflation above 3pc Telegraph, Edmund Conway (21/4/10)
Data
Latest Inflation data National Statistics Online
Consumer Price Indices portal National Statistics Online
Consumer Price Indices, Statistical Bulletin Office for National Statistics
Consumer Price Indices, time series data National Statistics Online
Retail Prices Index: 1948–2010 National Statistics Online
Questions
- Why might the Monetary Policy Committee have to restrict growth to keep inflation manageable?
- What are some of the causes of rising inflation? Why are expectations so important?
- How is the CPI calculated to measure inflation?
- Normally, during a recession, we would expect economic growth to be poor, but inflation to be low and stable. How can we explain both poor growth and rising inflation?
- “Investors know that the UK government has more to gain from an unexpected bout of inflation than almost any other economy.” Why is this?
As the global recession began to take hold during 2008, so many commodity prices plummeted. Oil prices fell from over $140 per barrel in mid July 2008 to around $35 per barrel by the end of the year (a mere quarter of the price just 6 months previously). From early 2009, however, prices started rising again and have continued to do so during 2010. By mid April 2010, the price of oil had risen to $85 per barrel.
And it’s not just oil prices that have been rising. The prices of metals such as copper, nickel and zinc have been soaring. Since the beginning of February 2010, copper prices have risen by 18%, zinc prices by 20% and nickel prices by 46%. As the article from the Independent states:
The Office for National Statistics said that the input price index for materials and fuels purchased by the manufacturing industry rose 10.1 per cent in the year to March and rose 3.6 per cent between February and March alone. The ONS added that prices of imported materials as a whole, including imported crude oil, rose 4.4 per cent between February and March.
Much of the explanation for this has been the global recovery. But while raw material prices have been rising, grain prices have been relatively steady and recently have fallen. So how can this be explained? The answer, as always with commodity prices, lies with demand and supply, as you will see when you read the following articles.
Articles
Commodity prices fuel inflation spike Independent, Sean O’Grady (10/4/10)
Interest rates may have to rise sooner after figures point to inflation rise Guardian, Katie Allen (9/4/10)
Pound rises as UK producer prices hint at inflation BBC News (9/4/10)
Petrol price hits record high BBC News (8/4/10)
China commodity imports soar despite high costs Reuters (10/4/10)
March Output Price Inflation Highest Since Nov 08 Marketnews.com (9/4/10)
Spring season: What is pushing up the price of copper and other base metals? The Economist (8/4/10)
Factory gate price rise leads to fear of inflation Financial Advice (9/4/10)
Corn Falls as Warm, Dry Weather Will Aid Planting in the U.S. BusinessWeek, Jeff Wilson (8/4/10)
Wheat Futures Fall as U.S. Exports Slump, Global Crop to Gain BusinessWeek, Tony C. Dreibus (9/4/10)
Commodities: Chinese imports defying commodity−price rally for now FZstreet.com, Danske Research Team (12/4/10)
Data
Commodity prices can be found at the following sites:
Commodity price data BBC News: Markets
Commodity prices Index Mundi
World Crude Oil Prices U.S. Energy Information Administration (See, for example, Brent Crude Oil Prices)
UK factory gate prices can be found at:
Latest Producer Prices Office for National Statistics, and
Producer Prices portal Office for National Statistics
Questions
- Use supply and demand analysis to explain why raw material prices have risen so rapidly. Illustrate your answer with a diagram.
- Use supply and demand analysis to explain why grain prices have fallen. Again, illustrate your answer with a diagram.
- What is the significance of income elasticity of demand and price elasticities of demand and supply in explaining the price changes in questions 1 and 2?
- How would you estimate the likely effect of a 1% rise in (a) general raw material prices and (b) factory gate prices on the rate of consumer price inflation?
- Why has the price of petrol risen above the level of July 2008, given that oil prices now are only about 60% of those in 2008?
- Why has a rise in factory gate prices led to a rise in the sterling exchange rate?
- If inflation rises as a result of a rise in commodity prices, what type of inflation would this increase in inflation be? Does the answer depend on what caused the rise in commodity prices?
A keenly awaited Budget, but what should we have expected? Chancellor Alistair Darling had warned that it wouldn’t be a ‘giveaway’ budget. The aim to cut the budget deficit in half over 4 years still remains and the UK economy is certainly not out of the woods yet.
You’ve probably seen the debate amongst politicians and economists over what should happen to government spending and it might be that the lower than expected net borrowing for 2009-2010 provides a much needed boost to the economy. With the election approaching, it seemed likely that some of this unexpected windfall would be spent. The following articles consider some key issues ahead of the 2010 Budget.
Budget 2010: Alistair Darling’s election budget BBC News, Stephanie Flanders (21/3/10)
Build-up to the Budget Deloitte, UK March 2010
Pre-Budget Report: What Alistair Darling has announced before Guardian, Katie Allen (9/12/09)
Budget 2010: Darling warns of ‘no giveaway’ BBC News (11/3/10)
FTSE climbs ahead of UK Budget Financial Times, Neil Dennis (24/3/10)
Bank bonus tax could net Treasury £2bn, E&Y says Telegraph, Angela Monaghan (24/3/10)
Alistair Darling set for stamp duty move BBC News (24/3/10)
Labour has run out of steam, says David Cameron Guardian, Haroon Siddique (24/3/10)
Ten things to look out for in the 2010 Budget Scotsman (24/3/10)
Sammy Wilson predicts ‘neutral budget’ BBC News, Ireland (24/3/10)
Do the right thing, Darling Guardian (24/3/10)
What do we want from the Budget? Daily Politics (23/3/10)
Budget boost for Labour as inflation falls to 3% TimesOnline (24/3/10)
Questions
- Why has the FTSE climbed ahead of the Budget?
- Why is there a possibility of a rise in stamp duty again? To what extent do you think it will be effective?
- Net borrowing for 2009/10 is expected to be lower than forecast. What should happen to this so-called ‘windfall’?
- What is expected from the Budget 2010? Once the Budget has taken place, think about the extent to which expectations were fulfilled.
- Why are excise duties on goods such as taxes and alcohol likely to be more effective than those on other goods?